July 03, 2006

Markets are Social

If you have any doubt that markets are conversations, literally, there is a new paper by Peter Kollock of UCLA and E. Russell Braziel of Bentek Energy onHow Not to Build an Online Market: The Sociology of Market Microstructure (pdf). Using the boom (and bust) of B2B Exchanges as a period to study the greatest creation of new markets in history, they explain how transaction efficiency doesn't foster liquidity in and of itself. Through an analysis of the propane markets in Texas and California, they show the role of social capital in markets and technology implications. Whereas in a liquid market, problems can largely be solved through price -- new, small and fragmented markets rely on conversations to gain "market color" and favors to do deals.

Quoting liberally:

The interconnected networks of relationships were important because of the structural roles of intermediaries, but these networks were also key because of the informal economy of favors that flowed through these social relationships. Solving problems is a central function of many market participants, and the key risk the individual is concerned with is career risk -- the extent to which their job or their bonus is on the line. Having friends in the network to turn to for favors in order to solve problems is critical. Economies of goods rest on economies of favors.
The informal insurance that comes from the flow of favors is a particularly important example of relational contracting "informal agreements sustained by the value of future relationships" (Baker, Gibbons, and Murphy 2002; cf. Macaulay 1963). Contracts can be a formal means of dealing with some of the risks of transactions, but informal means of managing risks are fundamentally important for at least two reasons. First, contracts simply cannot cover all the possible things that can go wrong.Second, formal approaches to dealing with the risks of transactions can be exceedingly, even prohibitively, expensive. A transaction that does not rest
at least in part on trust and the flow of favors is an expense that can rarely be afforded

This social capital approach to risk management is an important feature even in the centralized Texas market, and dominates the dynamics of sub-markets such as California propane. To date, the study of the informal economy and informal risk management has focused more on such setting as traders in the slums of Ghana (Hart 1988) or agricultural traders in Madagascar (Fafchamps and Minten 2001), but first-world energy markets may have more in common with third-world agricultural traders than might first be thought. This is not to say that markets in the US are more "backwards" than is commonly thought, but to make the point that an informal layer in markets is both inevitable and often provides key functions for the successful operation of the market. As the former CEO [actually, President & Co-founder] of a B2B bandwidth exchange commented:

Somewhere around the peak of the boom we forgot something. That lowly phone broker who knew how to make money in the market. ... They didn't talk about efficient systems. They talked about talk, [the] guy they knew they could extend credit or cut a deal [with] because they knew they would get it back when they needed it. Just like the phone brokers from a couple of years before, they knew markets were relationships. Markets are social. (Mayfield 2005)

Yep, that's me. And it is no coincidence that the experience I had with commodity markets led me towards building social software for a living. In some cases, for people who get both worlds, like JP Rangaswami (ping), who recently made similar points on the use of social software in risk management:

Markets are conversations, as per Cluetrain.

Markets contain risk.

Conversations can help you manage that risk.

Social software can help you extract what you need from those conversations and thereby help you manage the risk.

JP excerpts from The Risk Management of Everything and Harnessing Hindsight to suggest the role of social software in risk management is collective enquiry and sensemaking around risk events. Unfortunately, when risk management is simply defensive, cultures punish failure which prevents learning about latent (and fat tail) risks. Managing the unknown requires making the known transparent, but to do so, requires trust.

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Markets are Social

If you have any doubt that markets are conversations, literally, there is a new paper by Peter Kollock of UCLA and E. Russell Braziel of Bentek Energy onHow Not to Build an Online Market: The Sociology of Market Microstructure (pdf). Using the boom (and bust) of B2B Exchanges as a period to study the greatest creation of new markets in history, they explain how transaction efficiency doesn't foster liquidity in and of itself. Through an analysis of the propane markets in Texas and California, they show the role of social capital in markets and technology implications. Whereas in a liquid market, problems can largely be solved through price -- new, small and fragmented markets rely on conversations to gain "market color" and favors to do deals.

Quoting liberally:

The interconnected networks of relationships were important because of the structural roles of intermediaries, but these networks were also key because of the informal economy of favors that flowed through these social relationships. Solving problems is a central function of many market participants, and the key risk the individual is concerned with is career risk -- the extent to which their job or their bonus is on the line. Having friends in the network to turn to for favors in order to solve problems is critical. Economies of goods rest on economies of favors.
The informal insurance that comes from the flow of favors is a particularly important example of relational contracting "informal agreements sustained by the value of future relationships" (Baker, Gibbons, and Murphy 2002; cf. Macaulay 1963). Contracts can be a formal means of dealing with some of the risks of transactions, but informal means of managing risks are fundamentally important for at least two reasons. First, contracts simply cannot cover all the possible things that can go wrong.Second, formal approaches to dealing with the risks of transactions can be exceedingly, even prohibitively, expensive. A transaction that does not rest
at least in part on trust and the flow of favors is an expense that can rarely be afforded

This social capital approach to risk management is an important feature even in the centralized Texas market, and dominates the dynamics of sub-markets such as California propane. To date, the study of the informal economy and informal risk management has focused more on such setting as traders in the slums of Ghana (Hart 1988) or agricultural traders in Madagascar (Fafchamps and Minten 2001), but first-world energy markets may have more in common with third-world agricultural traders than might first be thought. This is not to say that markets in the US are more "backwards" than is commonly thought, but to make the point that an informal layer in markets is both inevitable and often provides key functions for the successful operation of the market. As the former CEO [actually, President & Co-founder] of a B2B bandwidth exchange commented:

Somewhere around the peak of the boom we forgot something. That lowly phone broker who knew how to make money in the market. ... They didn't talk about efficient systems. They talked about talk, [the] guy they knew they could extend credit or cut a deal [with] because they knew they would get it back when they needed it. Just like the phone brokers from a couple of years before, they knew markets were relationships. Markets are social. (Mayfield 2005)

Yep, that's me. And it is no coincidence that the experience I had with commodity markets led me towards building social software for a living. In some cases, for people who get both worlds, like JP Rangaswami (ping), who recently made similar points on the use of social software in risk management:

Markets are conversations, as per Cluetrain.

Markets contain risk.

Conversations can help you manage that risk.

Social software can help you extract what you need from those conversations and thereby help you manage the risk.

JP excerpts from The Risk Management of Everything and Harnessing Hindsight to suggest the role of social software in risk management is collective enquiry and sensemaking around risk events. Unfortunately, when risk management is simply defensive, cultures punish failure which prevents learning about latent (and fat tail) risks. Managing the unknown requires making the known transparent, but to do so, requires trust.